China's Central Bank Gets Its Yuan On

The 1.3 percent decline in the Chinese yuan against the dollar during the past week says little about China's long-term growth outlook and a lot about the central bank's willingness to flex its muscles.

To understand why, remember that the People's Bank of China has firmly managed the exchange rate ever since the mid-1990s. As with everything else, the price of a currency is determined by the interactions of buyers and sellers, whether they are businesses looking to build factories or households trying to find the best places to allocate their savings. To fix prices, the PBOC announces a target rate and then buys (or sells) enough assets denominated in other currencies, such as U.S. Treasury bonds, to offset the flows of capital from domestic and foreign investors. This job is made easier by regulations that limit these capital flows. Reformers in China know that this hurts households and encourages excessive investment, which is why they have pushed for the "internationalization" of the currency as a way to break down the existing capital controls.

In a separate vein, China's super-rich have proven quite adept at sneaking their assets into other countries, especially those such as Canada and Australia that make it easy to obtain citizenship if you buy a lot of property -- a smart strategy for those worried about unrest over rising inequality, or ending up on the losing side of a factional dispute.

From the middle of 1995 through the middle of 2005, the yuan traded at 8.3 to the U.S. dollar, with almost no variation. This wouldn't have happened if the PBOC's foreign assets hadn't grown from about $73 billion to about $725 billion during that period. Private investors were clamoring to move money into China to take advantage of its rapid productivity growth. This should have translated into rising household incomes, an appreciating currency and the emergence of a trade deficit. That's what happened in the U.S. in the second half of the 19th century, as the country imported capital from the U.K. and the Netherlands to support investments in infrastructure and manufacturing. Yet the yuan remained cheap because the Chinese central bank sold trillions of yuan propping up the value of the U.S. dollar.

Partly in response to pressure from the U.S. and partly to offset rising commodity prices, the Chinese government let the currency appreciate 35 percent since mid-2005. The yuan would have appreciated far more, if the Chinese central bank hadn't intervened by buying $3.1 trillion worth of foreign assets.

Investors have been trying to get around the capital controls this whole time. Foreigners who expect that China will eventually stop suppressing its exchange rate find creative ways to get money inside to profit from what they see as the inevitable appreciation of the yuan. The danger is that this hot money can leave as quickly as it arrived, which would destabilize the Chinese economy. China could get out ahead of the speculators with a surprise revaluation of the yuan that raised the currency 30 percent to 40 percent higher, after which the currency would float freely.

This line of thinking could also explain the sudden depreciation. There is no better way for the PBOC to discourage people from betting on the yuan's appreciation than suddenly shoving the currency in the other direction.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)

To contact the writer of this article: Matthew C. Klein at mklein62@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.

Matthew C. Klein writes for Bloomberg View about the economy and financial markets. He previously wrote for the Economist magazine and its economics blog, Free Exchange.
Before that, Klein was a research associate at the Council on Foreign Relations, where he spent more than two years studying the history of the Federal Reserve and the intellectual history of monetary economics for an upcoming book by Sebastian Mallaby. He also worked at Bridgewater Associates, where he studied the economies of Central and Eastern Europe and advised institutional investors on asset-liability management. Klein has a bachelor's degree in history from Yale University. Originally from Chicago, he lives in New York.
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